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Thursday, June 13, 2013

In India most investors go to any extent to save income tax and run
around to make last minute investments. Last minute tax planning is an
age old practice that forces tax payers to make hasty and often wrong
decisions. Typically, some individuals invest more than the required
amount to save taxes. They also end up parking money in wrong products
in the process, which may have an adverse impact on their cash flows and
return prospects.
It is not surprising that the insurance industry do most of its
business during the tax- saving season between January and March every
year. Often investors tend to buy products or make investments without
doing the due diligence on their total tax structure. Investors happily
write out cheques to buy low-yield traditional insurance policies or
take additional medical cover as long as it saves their income tax. But
this enthusiasm to avoid the taxman is missing when they invest in debt
instruments.
Your tax-saving investments should depend on your financial needs and
goals. These should be distributed among assets classes to reap the dual
advantage of lowering tax burden as well as building your portfolio.
Equities are known to offer high return over the long term. However, it
does not mean you should ignore debt investments.

The safety factor of debt funds

Debt funds are a direct alternative and competitor for bank fixed
deposits. The primary areas of difference are safety and taxation (and
thus returns), with mutual funds holding the advantage in tax-adjusted
returns and fixed deposits in safety.
In theory, banks are safer but, there is no practical difference
between the safety level of banks and debt funds as far as defaults of
underlying investments go. As with all mutual funds, there are no
guarantees in debt funds. Returns in debt funds are market-linked and
the investor is fully exposed to defaults or any other credit problems
in the entities whose bonds are being invested in.
However, in practice, the fund industry is closely regulated and
monitored by the regulator, Securities and Exchange Board of India
(SEBI). Regulations put in place by SEBI keep tight reins on the risk
profile of investments, on the concentration of risk that individual
funds are facing, on how the investments are valued and on how closely
the maturity profile hews to the fund's declared goals.
In the past, these measures have proved to be highly effective and
except for some small problems during the 2008 global financial crisis,
debt fund investors have not had any nasty surprises. Practically
speaking, you would be entirely justified in expecting not to face any
defaults in your debt fund investments.
Fixed deposits, recurring deposits and small savings schemes get a big
chunk of the household savings pie, while tax-efficient debt funds make
do with small fragment. More than Rs 4,90,000 crore of household savings
are in bank deposits, while debt fund investments by individuals add up
to about Rs 18,300 crore. This minuscule allocation to debt funds is
despite the huge tax advantage and other benefits that these schemes
offer.

The effect of tax differential

Returns from bank fixed deposits are interest income and as such have
to be added to your normal income. Since many investors are in the top
(30 per cent) tax bracket, this effectively reduces return by an equal
percentage.
With debt funds, the returns are classified as capital gains for
investments of over 12-months for and are thus taxed at 10 per cent or
20 per cent with indexation which adjusts for inflation during the
holding period. If you take into account indexation benefits, then the
difference between FD returns and debt fund returns are quite large. And
if you can time the investment to get double indexation benefits for
say a 370 day deposit, then it’s quite a bonanza. Below is an
illustration of effective returns from both the avenues;

Particulars

Income Funds

Bank Fixed Deposit

Investment Amount (Rs)

1,00,000

1,00,000

Rate of Return/Interest Rate (%) (p.a.)

10%

10%

Tenure (Days)

366

366

Gross Value after 1 year (Rs.)

1,10,000

1,10,000

Gain on Investments

10,000

10,000

Capital Gain Tax (@11.33%)

1,133

-

Tax on Interest Income (@30.9%)

-

3,090

Net Value after tax (Rs)

1,08,867

1,06,910

Effective Rate of Return (%)

8.87%

6.91%

Postponing the tax liability

The lower tax rate on capital gains, for instance, is just one of the
benefits of these schemes. A major draw is that one can indefinitely
postpone tax liability by investing in debt funds. The interest income
is taxable on an annual basis, irrespective of the time that investor
actually get it. Investor need to pay tax on the interest accruing on a
cumulative fixed deposit or a recurring deposit even though the
instrument has to mature in 5-10 years.
On the other hand, investments in debt funds will not have a tax
implication till it is withdrawn. This also makes these funds the best
way to invest.

Taking Advantage of Clubbing of Income

When the money is invested in minor child's name, the income from the
investment is treated as that of the parent who earns more. This
clubbing of income is meant to prevent tax leakage, but investments in
mutual funds can circumvent this provision. If the funds are redeemed
after the child turns 18, the capital gains will be treated as the
child’s income, and not parents.

Setting off Losses

There are other ways to earn tax-free income from debt funds. You can
set off losses from other assets against the gains from these schemes.
Tax rules allow carrying forward of capital losses for up to eight
financial years. For instance, if you had booked short-term losses on
stocks and equity funds when the markets slumped in December 2008, you
can adjust them against the gains from your debt fund investments till
2015-16.
What if you need the money before one year? Any short-term capital gain
is taxed as income, but you can get past this with the dividend
advantage. Though they are tax-free, dividends of debt schemes reach the
investor after the deduction of dividend distribution tax. This is
13.8% for debt funds and 27.4% for liquid funds. Even so, this is lower
than the 30% tax an investor in the highest income bracket will pay on
withdrawals before one year of investment.

Liquidity Advantage

Apart from these tax advantages, debt funds also offer a higher
liquidity and more flexibility than a bank deposit. When you invest in a
fixed deposit, you lock up money for a certain period. Sure, the
deposit can be broken any time, but you end up sacrificing returns.
There is usually a small penalty to be paid when you withdraw
prematurely.
Debt funds also levy an exit load, but the quantum of load as well as
the minimum period of investment varies across funds and categories.
Most liquid funds and ultra short‐term funds, for instance, do not have
exit loads, but medium‐term income funds may charge 0.25‐0.5% if you
leave within six months or a year of investment. In some cases, this may
even be as high as 1‐2%. So it pays to check the exit load and minimum
investment period before you buy a fund.

Flexibility

The other advantage is the flexibility and ease of investment. The
Public Provident Fund has annual limits—the minimum investment is Rs.500
and the maximum Rs 1 lakh. The tenure is fixed at 15 years but can be
extended in tranches of five years. The Senior Citizens Savings Scheme
has a maximum limit of Rs 15 lakh per individual and is for five years.
No such limits apply to mutual funds. You can invest as much as your
pocket allows. "Unlike small savings schemes, there is no limit to how
much an individual can invest in debt funds,"
Besides the convenience of SIP investing, facilities such as systematic
transfer plans (STPs) and systematic withdrawal plans (SWPs) make
things easier for the debt fund investor.
Unaware of debt funds as a fixed income product, many investors opt for
Banks fixed deposits or small savings schemes. But, Debt funds if used
properly and selected wisely can be a good alternative to other fixed
income investments.

The Economic Times - ગુજરાતી

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"I or my company idevelop do not make any warranties, express or implied, as to results to be obtained from using the information in this blog. Investors should obtain individual financial advice based on their own before making any investment decisions."

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